ANALYSIS-New rules point to demand surge for Aussie bonds

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By Cecile Lefort
SYDNEY, Sept 25 (Reuters) – Proposed regulations would make Australian banks big buyers of government debt, adding fuel to what is already the biggest rally in 10-year bonds in developed countries in recent months.
Australian government 10-year bond yields have fallen faster than those in the United States, euro zone and Britain since they peaked in June as a surprisingly resilient economy led investors to rapidly scale back their expectations for future issuance.
The rally and Australia’s relatively high interest rates have already pulled in a record amount of foreign investment.
While supply may tighten, demand may also rise sharply as the country’s banks could be required to buy billions of dollars in government bonds under proposals designed to strengthen their balance sheets so they are better prepared in the event of another financial crisis.
“In a relative value sense, bonds have gone from very weak in June/July, to already showing significant signs of improvement and that should continue,” said Matt Johnson, senior economist at UBS.
“Against swaps or futures, short-end bonds will be the area where you’ll see outperformance.”
In May, the Australian government unveiled its largest deficit on record for the fiscal year to next June and it forecast a decade of debt in a budget designed to nurse the economy through the global downturn.
But the economy has proved irrepressible, producing the strongest performance in the developed world so far this year and importantly avoiding recession.
After betting the government would issue over A$220 billion ($193 billion) in bonds by 2012, markets now see supply of A$150 billion or less.
“We’ll go back to a budget surplus quicker than the government currently expects… within five years I would have thought,” said Sally Auld, rate strategist at JPMorgan in Sydney.
Since peaking at 5.97 percent in June, yields on government 10-year bonds have declined to 5.32 percent, a fall of 65 basis points, even as Australia proved to be the only major developed economy that expanded in the first half of the year.
Yields on similar government bonds in the United States, euro zone and Britain also fell, but by much less. U.S. 10-year yields dropped 57 basis points, and the euro zone and Britain by just over 30 basis points.
Now a discussion paper from Australia’s financial services regulator raises the prospect of a massive increase in demand for government securities, analysts say.
The Australian Prudential Regulation Authority says banks need to hold more Australian government bonds or treasury notes as liquid assets to help them weather any potential future funding crises.
“[This] implies a massive uplift in bank demand for government securities,” said Peter Jolly, head of research at National Australia Bank.
Indeed, if history is anything to go by, the proposal would have a dramatic impact.
Jolly estimated that if banks were to hold 5 percent of their total domestic assets as liquid government securities — as they did in the mid 1990s — they would need to own A$122 billion in government bonds and treasury notes.
“This is more than the outstanding level of government securities, which totalled A$108.5 billion at the end of August,” he said.
Banks currently hold just 0.8 percent, or A$19 billion, of their domestic assets in government securities.
Ultimately the regulations may have to include top-rated state debt and supranational bonds, or those issues in Australian dollar by triple-A rated overseas issuers, to avoid a market stampede, they said.
The proposals do not include any specific levels for suggested liquid assets, but APRA wants the new framework, the likes of which are being considered by policymakers globally, finalised by the middle of this year. [ID:nSP401347]
“The rationale for reform means policymakers will likely press for as much change as possible, which should impact the demand for bonds and could put a bid-tone under the market for years to come,” said Adam Donaldson, head of debt research at Commonwealth Bank of Australia.
Australia’s top banks are currently required to hold around 7-10 percent of their assets in liquid securities, while credit unions typically hold around 15 percent.

FROM OVER-SUPPLY FEARS TO BOND SHORTAGE
The government ran budget surpluses for six years until 2008, keeping issuance at low levels, so investors have become used to the relative rarity of Australian sovereign debt.
Australia’s relatively high interest rates have attracted a surge in investment from overseas. Foreign investors owned a record high 66 percent of the market in March, up from 59 percent a year ago, National Australia Bank data shows.
“For central banks, yield is going to become quite important; there is an important yield differential between Aussie bonds and European or U.S. bonds and that will continue to make our bonds attractive,” said Sally Auld, rate strategist at JPMorgan in Sydney.
The government is not due to provide an update on its budget position until the middle of November. Although the government may well reduce its forecast borrowing needs, dealers said it should be careful how deeply it cuts because large investors put liquidity at the top of their investment priority in selecting where to risk their capital. (Editing by Neil Fullick)
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